Wednesday, August 04, 2010

A Long Boring Post on Economic Coordination

This post is intended as a bit of a reference point more than anything else, I've long been meaning to write a post like this as a reference to use in future posts.

The best way to consider the concept of economic coordination is to consider the economy as a network of interconnected economic relationships between economic actors. Some will be of a permanent nature (employment contracts, long term contracts and working relationships between firms), others can be implied from patterns of individual transactions (for example, a newsagent might sell around 10 newspapers a day, the individuals buying the newspapers may be different but the volume and nature of the transactions will fit a generalised pattern).

There are two points to make about this coordinated network that it is this coordinated network of economic relationships that provides both the supply and the demand in the economy, disruption of the network destroys productive economic capacity, it can often have knock on effects through the network.

The second point leads on from the first and this is that some destruction of capacity in the economy is both expected and indeed desirable. The network is not static but constantly adapting and changing, new businesses are created as old ones are destroyed. If a firm develops a new method of producing a good, it's likely that the old producers of this good will go out of business. However the labour used in the old processes is now free to be put to alternative uses, this means that new businesses will spring up using this excess labour. This process was originally described by Joseph Schumpeter who coined the term creative destruction.

Some on the right will follow this with the idea that all recessions are adjustments and that the destruction that occurs in recessions leads to new economic activity to replace that which was lost. This is not necessarily the case, the creation of new economic activity is a slow process dependent on the presence of entepreneurial talent to make use of the available resources. The creation of new jobs is a slow and uncertain process.

My final note on coordination is that the ultimate danger of any economic threat, be it inflation, recession or some other shock is that the coordinated network of the economy unravels. This leads to the destruction of economic capacity with it's accompanying decline in standard of living as well as the social problems of unemployment. The ultimate aim of economic policy should be to prevent this occurence.